Ineffective VAT Increase
From dis-Emi-A
This is a general, and simplified view, of what happens when the VAT in a country is increased. We'll consider the 3% increase that Germany is implementing as of 2007.
Contents |
Before
Jim makes enough money to have 5000€ disposable income. Jim, like far too many people, doesn't much of a financial forsight and thus spends all of his disposable income in the year. The current VAT rate is 16%, thus Jim ends up giving the government 800€.
To simplify this, we'll assume he gives it all to the company ElectroToys. We'll also assume this is a very gifted company which doesn't manage to spend money other than on salaries, thus the remaining 4200€ ends up directly in Sally's pocket, which is for her disposable income. She in turn spends it all and the government collects their 672€.
This happens over a course of several years. The following table shows the life of the original 5000€
| Year | Disposable | Year VAT | Total VAT |
|---|---|---|---|
| 1 | 5000 | 800 | 800 |
| 2 | 4200 | 672 | 1472 |
| 3 | 3528 | 564 | 2036 |
| 4 | 2963 | 474 | 2510 |
| ... | |||
| 7 | 1756 | 281 | 3524 |
| 10 | 1041 | 166 | 4125 |
As you can see from the table, by the tenth year over 80% of the money has been collected as VAT in total.
After
Now the VAT has been raised to 19%.
Jim again starts with 5000€ disposable income. But this time when it all arrives at ElectroToys, 950€ have been taken from the government, so ElectroToys earns 150€ less than before the change. Now, ElectroToys, like most corporations, doesn't want to earn less money, so instead they decide to lower Sally's salary by 150€ (or they hold back an increase, which is effectively the same if you wind inflation into this story). That means that Sally has only 4050€ to spend, rather than 4200€. Though, thanks to the increased VAT the government still earns more from Sally now than before.
So let's look at the progression further.
| Year | Disposable | Year VAT | Total VAT | % Revenue Change |
|---|---|---|---|---|
| 1 | 5000 | 950 | 950 | +19% |
| 2 | 4050 | 769 | 1719 | +15% |
| 3 | 3280 | 623 | 2342 | +10% |
| 4 | 2657 | 504 | 2847 | +6% |
| ... | ||||
| 10 | 750 | 142 | 4392 | -11% |
On this table we've included the % Revenu Change column which indicates how much money the government makes from VAT per year in the new system as compared to the old. And it is with this we see the very interesting year 7, a year in which the government starts earning less from VAT then before. Yes, that means the raise in VAT actually reduces the yearly VAT revenues starting from the 7th year.
Thus the increased VAT only increases revenues in the short-term at the expense of long-term revenue.
Alternate Scenario
What if the government reduced the VAT by 3% instead of increasing? That is a good question to ask, let's look at just a few key years.
| Year | Disposable | Year VAT | Total VAT | % Revenue Change |
|---|---|---|---|---|
| 1 | 5000 | 650 | 650 | -19% |
| 2 | 4350 | 565 | 1215 | -16% |
| 8 | 1886 | 245 | 3358 | +4% |
| 10 | 1427 | 185 | 3757 | +11% |
The first few years look quite bad for the government, they just won't be making as much money. But have a look at year 8. As of that year they start having increased revenues yearly.
Questions / Criticism
- But the Total VAT collected goes up over time?
- That is true, but in budgetting it is the yearly numbers which are of most importance. The reason being is that all the revenue for a year is typically spent on things which are not generally asset pools for the government, that is, in the following years they don't financially benefit from previous expenditures. The exception to this would be a debt reduction plan, in which case high revenues in the first years could actually make a lot of sense.
- Sally receiving 150€ less is not the same as her be denied a raise!
- Technically correct, but the overall impact is the same. Every year there is a certain amount of inflation in the economy, this has the effect of devaluing money, usually companies offer yearly salary adjustments which should at least offset this effect. Should this yearly increase not be offered, Sally's purchasing power is reduced.
- Hold on though, but the government does really receive more money if Sally just doesn't get a raise rather than a reduction!
- Not quite, the government also spends the money it receives, and it is not immune from inflation. So, just like Sally, the government is expecting everybody to get a yearly increase, otherwise their revenue is also effectively reduced.
- What if ElectroToys decides to give Sally a raise despite earning less money?
- In this situation the increase in VAT may be better for the government, or it could be worse. If the company earns less money, it also means they will be paying less corporate taxes. So to really see whether the government earns more one would need to do a projection including the corporate tax rate as input.
- So why is the VAT being raised if it clearly won't help?
- Well, the calculation does get a little more complex than this, as more variables need to be considered, but the general pattern should be right. A significant part of the reason why such projections don't impress enough on the government is that the negatives only start appearing after 7 years -- which if you compare to a 4 year election cycle you can start to see some long-term interest problems. Indeed, since the first few years are such a great boon, an increase can almost guarantee a subsequent election win, followed of course by plenty of excuses in the 7th year as to why there is no money again.
- Couldn't the same projection be done for income tax and corporate tax though, coming to the same conclusion that any increase is bad?
- In principle similar patterns apply, though the aspect of disposable income makes the VAT situation simpler than the other (as the VAT is applied after salaries, it doesn't directly alter the earnings of an indivudal like income tax would). This theory isn't new however, with a bit of digging you can find several economic theories showing how high tax rates (regardless of type) actually hurt the economy and government as a result.
- If that is true, how did tax rates ever get so high in the first place?
- Well, firstly refer to the question about why would this be done at all. Secondly, for lower tax rates, increasing the rates actually has a long term improved situation. For example, if the VAT was currently 3%, and the government decided to increase it to 5%, the government intake would significantly improve over the following years, and even 20 years later would still be 12% better (though at 26 years it drops to -1% and then continues to fall).
- So even in the 3% to 5% case it is ultimately bad!
- In all cases tax increases are supposed to be temporary measures to fix a broken system. In the given scenario the government has 25 years to actually fix the economy before the negatives of the tax increase are seen. This is quite possible, especially if part of recovery plan is debt reduction. However, in the 16% to 19% scenario the government has only 7 years with which to fix the system -- and since in the example case no actual debt reduction strategy is being considered in those 7 years, the chance of success if dismally low.
Please ask any more you have and they will be answered.
